Are equities cheap right now?

But with global macroeconomic conditions improving, and interest rates likely having peaked, even potentially falling, are we at the point where equities are cheap?

The S&P 500 index of US stocks reached an all-time high of more than 5,000 at the start of February, and within that is the key to understanding whether equities really do represent good value right now, says James Sullivan, head of partnerships at Tyndall. 

He says: “The valuation of the equity market is hugely polarised, with the US trading at a significant premium to the rest of the world. The premium it currently commands compared to the MSCI world average is ripe, as high as 40 per cent if considering price to book.

"Some commentators suggest that this is just a magnificent seven phenomenon, and those stocks distort the multiple. This is true to an extent, however stripping them out is not perhaps as material as one might have expected; price to earnings falls from 24x to 21.5x, price to sales falls from 2.7x to 2.2x and price to book 4.7x to 3.8x.” 

He says that while it is reasonable for US equities to trade at a premium to other equity markets, he feels the current valuation level is above that stock market’s long-term average, implying that the market is “fully valued”.

Jordan Sriharan, multi-asset fund manager at Canada Life Asset Management, says that if one excludes the returns from the seven large-cap technology stocks, the earnings growth achieved by the rest of the market has been “flat”, and this may explain why that part of the equity market looks expensive. 

Evan Brown, head of multi-asset strategy at UBS Asset Management, says the number of questions he gets from clients sceptical of his bullish view on global equities right now is around valuations.

He says: “[They ask], 'don’t high forward price-to-earnings ratios mean that all the good news is already priced in, and stocks will be hard-pressed to make further gains?'

"We believe high multiples are the latest brick in the wall of worry that global equities will climb on their way to fresh all-time highs."

David Jane, a multi-asset investor at Premier Miton, says he believes that outside of the largest technology stocks in the US, equity valuations are “pretty attractive everywhere”.

But he does not feel valuation is the only metric to consider, for two reasons: “The first point is valuation is not a good predictor of near-term performance. Second is down to the unpredictability of earnings and growth near term. What if growth and inflation reaccelerate, what if there is recession?

"Personally, I am influenced by valuation as I think it tells you something about risk; a low valuation and high yield offer a lot of protection against disappointment and vice versa.” 

Valuation is not a good predictor of near-term performance.David Jane, Premier Miton

Brown adds: “The macro backdrop suggests that earnings expectations – the most important determinant of returns over the tactical investment horizon – will continue to rise. And risk appetite, while improved, has not risen to extreme levels.

"We acknowledge, of course, that elevated multiples on global equities may limit the speed or magnitude of any future rally and make stocks more susceptible to unforeseen shocks."

Brown says he believes many equity markets will join those of Germany and the US in hitting record highs soon due to, in his view, the medium-term growth outlook for the global economy being the most promising it has been for many years. 

Brown’s view is that corporate earnings will therefore improve and justify the valuation multiples. 

Putting some context around that, Rupert Thompson, chief economist at Iboss, says: “[Recent] gains in US equities were once again led by the tech sector. This time, the good performance was sparked by good results from Arm, the UK chip designer. Its shares ended the week up 60 per cent and helped drive a 9 gain in Nvidia. 

"Overall, partly on the back of strong numbers from most of the magnificent seven tech stocks but also the unexpected strength of the economy, corporate earnings in the US are once again beating expectations.

"With around 65 per cent of companies now reported, the expectation is for S&P 500 earnings to be up a healthy 9 per cent than a year earlier."

Bargain hunting?

While both the US economy and stock market have soared ahead of peers so far in 2024, Tyndall's Sullivan does not believe that the slower growth in the rest of the world makes equities outside of the US particularly cheap.

However he says the merit of investing in markets outside of the US is that the types of stocks on offer in the rest of the world are different to those in the US market and so offer diversification. 

Sullivan adds that in valuation terms, the FTSE is one market that may be regarded as cheap.  

Data from Confluence shows that in 2024 so far, the stocks driving returns in the UK market are those which pay a yield, while in the US, it is the stocks that have growth characteristics that have been the primary driver of returns.

Corporate earnings in the US are once again beating expectations.Rupert Thompson, Iboss

Jane says that liquidity has become much more significant in markets in recent years, with central bank quantitative easing programmes boosting liquidity, thereby pushing up share prices, almost regardless of valuation levels. 

Thus it may be that the pace, scale and extent of the unwinding of QE in different markets in the coming years has a much greater impact on equity performance than do present day valuation levels transposed onto future economic conditions. 

Jane is quite positive on the prospects for the large-cap technology stocks in the US, believing that at current valuation levels they represent decent investments as long as they can grow earnings in line with nominal GDP in the US, but says he finds better value in other markets, including in US smaller company shares, and in European and Japanese equities. 

David Thorpe is investment editor at FT Adviser